If the Velocity of Money Picks Up Will Inflation Soar?

Mish

Let's explore the question with a definition of velocity and the related variables.

Velocity of Money Definition

The St. Louis Fed Defines Velocity as the ratio of GDP to Money Supply.

There are several components of the money supply,: M1, M2, and MZM (M3 is no longer tracked by the Federal Reserve); M1 is the money supply of currency in circulation (notes and coins, traveler's checks [non-bank issuers], demand deposits, and checkable deposits). A decreasing velocity of M1 might indicate fewer short- term consumption transactions are taking place. We can think of shorter- term transactions as consumption we might make on an everyday basis.

The broader M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals. Comparing the velocities of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving. 

MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand: notes and coins in circulation, traveler's checks (non-bank issuers), demand deposits, other checkable deposits, savings deposits, and all money market funds. The velocity of MZM helps determine how often financial assets are switching hands within the economy.

Shaky Ground

The Fed is on shaky ground. M1 consists of demand deposits (checking accounts). Demand deposits are supposedly available on demand but money most think of as being in their account is not there at all.

Regulations allow banks to move money in checking accounts to other accounts for overnight lending in a process called Sweeps.

The Fed used to publish Sweeps Data but stopped doing so on January 17, 2014. 

Since then, M1 is artificially low and M2 artificially high. I reconstructed M1 and M2 for a while, but money is now so distorted by Fed actions it's not worth the bother except to note that neither M1 nor M2 are what they claim to be. 

Velocity

There is M1 velocity (distorted), M2 velocity (distorted), M3 (discontinued), and MZM (extremely distorted) velocity.

M2 Velocity is what most economists mean when the word velocity is used so lets start there.

V = GDP / M2

It's important to note that velocity has no independent life of its own. 

GDP can be thought of as Prices * Transactions or (P * T).

This leads us to 

V = (P * T) / M2

Observations

  • Velocity can rise if prices fall if the number of transactions goes up.
  • Velocity can rise if prices stay the same and M2 goes down.
  • Velocity can fall if prices rise if M2 goes up
  • Velocity can fall if prices rise and the number of transactions drops.

Key Points

  1. Prices can rise, fall, or stay the same, no matter what velocity does.
  2. Velocity does not determine prices. 
  3. Velocity does not determine or even influence anything at all.

Myths Die Hard

I have discussed all this before, but the topic comes up again and again.

History Tells Us One Thing
ATL Money Velocity

Richard Duncan

Richard Duncan says "Velocity is no longer relevant."

That is true, but was velocity was ever relevant?

Not Much of a Relationship

Velocity vs CPI 1960-Present

A Fred post on M2 Velocity and Inflation accurately concludes "there is not much of a relationship."

A Fred scatter plot came to the same conclusion. 

The Fred chart is similar to mine. I used year-over-year percentage change comparisons to put everything on the same scale.

From 1960 until 1971 the US was still on a quasi-gold standard. What about earlier?

Velocity 1910-Present

Velocity 1910-present

Fred has a Historical Chart of Velocity that dates from 1869 to 1966. 

To that chart I added year-over-year M2 velocity and year-over-year CPI. 

Even in the 1920s, on a gold standard, there are periods when velocity and the CPI went in opposite directions. 

Part of the problem is how to measure inflation.

Is inflation best measured by consumer prices (CPI), producer prices (PPI), the Fed's preferred measure of Personal Consumption Expenditures (PCE) or something else?

None of those measures directly contain housing prices (now), but they used to. 

Changing Meanings

The Definition of Inflation has changed dramatically over time.

  • 1864: Webster's American Dictionary of the English Language in 1864, prices had been scuttled. According to that dictionary, inflation is: "undue expansion or increase, from over-issue; -- said of currency."
  • 1934: Disproportionate and relatively sharp and sudden increase in the quantity of money or credit, or both, relative to the amount of exchange business.
  • Now: Higher prices

My Inflation Definition

Inflation is an increase in money supply and credit, with credit marked to market. 

I use that definition because that is how the economy works. Banks stop lending when they are capital impaired or they perceive there are no good credit risks. 

Measurement Problem

A huge measurement problem exists. The Fed suspended mark-to-market accounting. Assets on the balance sheets of banks are now easily marked to fantasy. But fantasy prices won't last forever.

Another credit crunch (deflation) is on deck when asset prices fall. Meanwhile, that is why the Fed stepped up to the plate with a myriad of lending facilities.

The Fed Now Owns Over $2 Trillion in Mortgages, What Else?

For discussion of illegal Fed tactics, please see The Fed Now Owns Over $2 Trillion in Mortgages, What Else?

Circling Back to Velocity

We can surmise velocity is falling because money supply is soaring and prices didn't. But velocity did not cause that. It is a result, not a cause. 

Even if velocity picks up, prices may not. And what prices are we measuring anyway?

Velocity is a useless, inconsistent measure of something that has morphed over time yet never had an independent existence of its own.

Attempting to predict prices from velocity or velocity from prices is a  fool's mission.

Mish

Comments (20)
No. 1-16
PecuniaNonOlet
PecuniaNonOlet

35 days till election. Excellent question. I have seen food price inflation, especially around beef but almost none in a lot of other things, very curious. And at this point, how can anyone or any business be a good credit risk?

16 days till Boris Brexit Bonanza.
3 days till mass layoffs begin.

Soft_coding
Soft_coding

"Velocity is a useless, inconsistent measure of something that has morphed over time yet never had an independent existence of its own."

Can't we say the same thing about inflation?

Herkie
Herkie

"A huge measurement problem exists. The Fed suspended mark-to-market accounting. Assets on the balance sheets of banks are now easily marked to fantasy."

The FASB accounting change which legalized fraudulent reporting of asset values was limited to the TBTF mostly banks, but to other TBTF's like Ford and GM, and GE, the big commercial paper issuers. Especially those with giant government contracts, particularly DoD contracts. YOU try marking assets to any value you please and see how fast you go to prison.

This has undermined the US and EU as much as any caustic political discourse, it was the twin policy goods of full faith and credit as well as HONEST and uniform accounting procedures that established our western business and government success. Take for example russian or Chinese financial data, you cannot trust any numbers coming from either, their accounting systems do not conform to international norms and there are no active whistleblower protections for those that would reveal cheating in these places.

This is now also the case in the western world, you cannot rely on any data you read.

I used to follow and believe in the data, hell that was why I returned to college in my 30's and got a BS Finance degree. But that was prior to the end of honest reporting, or at least early into it when some data was still plausible.

I simply know this from anecdotal experience, the prices I have to pay for basics has absolutely skyrocketed while my CPI adjusted income has been stagnant at best. As long as there is a disconnect I just do not buy the claims that any of this has any relation to reality.

Between the end of 2013 and the end of 2019 those six years my pay increased by 6.8% while my basic monthly expenses rose by about 65% more than halving my standard of living. In fact, my housing expenses drove quite a lot of that, rents in Oregon where I lived in that period rose by pennies under 100% in that period. The inflation on other items was lower, but still multiples of what the government claimed it was. Notably if I apply their hedonics assumptions to my auto insurance it also has more than doubled while my record of flawless motoring has stayed the same.

Now I am told we will be getting best estimate for our next COLA based upon 2020 prices, 1.3% and I can only shake my head because I want to know where the BLS which does price data research is getting their numbers. It sure isn't at the Walmart I have to shop at. Covid has meant empty shelves there to this day, and buying online is an expensive farce, you try to buy something online only to see the error message that it is OUT OF STOCK forcing you to either not buy or buy a far more expensive substitute. Like when I went to buy a bag of weed and feed a few weeks ago, the only thing I could even find was Scott's Turf Builder at Home Depot at twice what I had to pay before because the two bags they had remaining in stock were the only two bags of weed and feed available.

You cannot get a legitimate read on prices when they use so many gimmicks like hedonics and substitution but there is no stock actually on hand. They would have to be making it up. I actually see some prices in stores that blow my mind, like salmon that was $9.99 per pound last year and $26.99 per pound this year, and that is repeated over and over and over, why it is as if nobody even has a clue to what those dollars are worth. Even fuel which was a bright spot for a few weeks this year has doubled since the lows and right back to where it was before Covid, even though driving is still way down. All that happened was refiners refined a lot less till overstock was drawn down.

In the end of course fundamental economic laws will again make themselves known because you cannot fool supply (production) and demand this long without some really dire consequences. To even try makes me suspect that TPTB know something they are not telling us, like that there will be no economy to worry about by say 2029. And no people to protest falling living standards or poverty.

dr smock
dr smock

From what I have seen, the price of goods and services in the US has gone up at least 10% in the last year. If the price has stayed the same, then the quality went down.

dr smock
dr smock

From what I have seen, the price of goods and services in the US has gone up at least 10% in the last year. If the price has stayed the same, then the quality has gone down.

Casual_Observer2020
Casual_Observer2020

Price stability in the face of decreased demand means inflation is high. Inflation should always be looked at through this lens.

Sechel
Sechel

M1,M2, M3 are too volatile to be of use and outside Fed control

Eddie_T
Eddie_T

Erased my long rant doing a final edit. No big deal, I do this for me anyway.

Short version.

Other than car prices and gasoline costs, the environment is clearly inflationary from a price appreciation standpoint for American citizens.....and while credit expansion is a good measure of inflation, that matters less to the average guy than whether his month ends with more unpaid bills or more cash left over.

The real cost of living by any rational metric is rising more than the Fed says it is...maybe 3-4X.

And credit expansion matters less to me as an investor......in fact these days less available debt leverage in uncertain times is probably a good thing.... :) But that's just me....and at the age when many people retire.

There have been times when I could have used more access to debt, and I was cut off because I'm not an elite. I do understand how that works.

But since inflation is very real and probably SIGNIFICANTLY higher than reported, I think it makes sense to make an investment plan that is benefited from an inflationary environment.

With the caveat that the entire system is quite unstable.........and massive deflationary events could happen.

To me that means saving and buying decent tangible assets with low leverage.

Eddie_T
Eddie_T

"Velocity can rise if prices fall if the number of transactions goes up."

That isn't happening.

"Velocity can rise if prices stay the same and M2 goes down."

That isn't happening either.

"Velocity can fall if prices rise if M2 goes up"

That is happening.....

"Velocity can fall if prices rise and the number of transactions drops."

That is probably happening too. Some combination of the last two is what caused the drop.....the scary thing is the way the VOM fell off a cliff, all of a sudden.

Isn't a steep drop in the velocity of money feared primarily as a harbinger of severe deflation?.....transactions falling to near zero as debtors use all available funds to deleverage and cut collateralized debt. Consumers put off buying durable goods.

I'd say the pandemic might have caused some of that. But non-housing debt seems to have flat-lined about Q2 of 2019.....maybe because housing debt keeps going up.

jfpersona1
jfpersona1

The velocity of money has always struck me as a 'fudge factor'.

The money supply is known (mfrgheeheehee - sure it is!) and the total economic output is known (uh huh - sure, right) and they are related by THIS MAGIC NUMBER!

Except the number isn't constant. And has no natural upper bound. And a meaningless lower bound. And has no reason to be any particular value.

Why do we care about this again?

Carl_R
Carl_R

It appears on the chart that the velocity was a leading indicator for inflation during the gold standard years. Once we moved to the 60's and beyond, there was no correlation at all, primarily because the Fed , and Congress were doing too much intervention. Take this year for example. Velocity crashed. Normally that would have led to massive deflation. But...the Fed and Congress stepped up and pumped money into the economy, preventing it.

So, in a world where the Fed and Congress are both actively intervening in the economy, velocity is no longer useful, if it ever was. Really, as jfperson1 said above, velocity has always been just a fudge factor, that drops out at the end of a calculation. You show me how to compute velocity without looking at financial aggregates, and then maybe I will agree that it has some independent existence and value.

Heckman1001
Heckman1001

Thanks a lot for the knowledge you shared! Keep it up https://www.upsers.pro/

https://www.upsers.pro/
Salmo Trutta
Salmo Trutta

Income velocity is a contrived figure. It is the transactions velocity of money, money actually exchanging counterparties that is telling. It is the transactions velocity of money that American Yale Professor Irving Fisher used in his truistic "equation of exchange". What Milton Friedman had printed on his license plate was wrong.

Dr. Philip George's definition of velocity is apropos: “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.” Unfortunately, in error, the FED discontinued publishing the Debit and Demand Deposit Turnover G.6 release in Sept. 1996.

Nevertheless, we know why Vt has fallen since 1981. Banks are "Black Holes". Banks are credit creators - not credit transmitters. All bank-held savings are un-used and un-spent, lost to both consumption and investment, indeed to any type of payment or expenditure. Banks pay for their earning assets with new money - not existing deposits. From the standpoint of the entire payment’s system, the monetary savings practices of the public are reflected in the velocity of their deposits and not in their volume.

Thus as the volume and proportion of bank-held savings increases, velocity decreases. The FDIC's increase in deposit insurance levels, from $100,000 to $250,000 decimated money velocity. The remuneration of interbank demand deposits decimated money velocity (inverted the short-end segment of money market funding rates for the nonbanks). The impoundment and ensconcing of monetary savings is responsible for the rival of Alvin Hansen's 1938 secular stagnation thesis - not demographics, not globalization, not robotics, not monopolization, etc.

Salmo Trutta
Salmo Trutta

Money velocity will continue to fall. Economists don't know a debit from a credit, money from mud pie.

The mispricing and mal-investment (suppression of interest rates) stems from the fact that adding infinite money products (QE-Forever), decreases the real rate of interest and has a negative economic multiplier. Whereas the activation and application of $15 trillion in finite savings products (near money substitutes), increases the real rate of interest, produces higher and firmer rates, and has a positive economic multiplier.

Salmo Trutta
Salmo Trutta

Frictionless financial perpetual motion requires that, income not spent (monetary savings, commercial bank-held savings) is quickly reintroduced into the economy, completing the circuit income and transactions’ velocity of funds (circular flow), thereby sustaining and promoting economic momentum. The utilization of savings via targeted real investment outlets has a positive economic multiplier (increases productivity, real wages, as well as the real rate of interest). The only way to activate monetary savings is for their owners, saver-holders, to spend/invest either directly or indirectly outside of the banks. I.e., savings flowing through the nonbanks never leaves the payments system, there is just an exchange in the ownership of pre-existing deposit liabilities in the payment's system (a velocity relationship, where money turns over but doesn't expand).

Salmo Trutta
Salmo Trutta

Rates-of-change in monetary flows, volume times transactions' velocity equals roc's in P*T in American Yale Professor Irving Fishers' truistic "equation of exchange" (where N-gDp is both a subset and proxy).

There is > 100 years of correlation and proof. The distributed lag effect of money flows are mathematical constants. Thus we know that short-term money flows are a proxy for real output. And long-term money flows are a proxy for inflation. This math still holds today.


Global Economics

FEATURED
COMMUNITY